Social relationship and business connections create implicit benefits between borrowers and lenders. We model how implicit benefits and repayment enforcement costs influence credit allocation, cost, and renegotiation. The optimal solution illustrates that financing with implicit benefits may achieve lower financing costs, higher managerial effort, and better outcomes for both borrowers and lenders. This result is consistent with the continuing expansion of alternative financing despite formal financial intermediation, the rise of corporate insider debt, and joint ownership of debt and equity. The growing size and complexity of projects and changes in community relationships can explain expansion of financing with standard intermediation.

This paper offers a framework to understand informal financing based on mechanisms to deal with asymmetric information and enforcement. We find that constructive informal financing such as trade credits and family borrowing that relies on information advantages or an altruistic relationship is associated with good firm performance. Underground financing such as money lenders who use violence for enforcement is not. Constructive informal financing is prevalent in regions where access to bank loans is extensive, while its role in supporting firm growth decreases with bank loan availability. International comparisons show that China is not an outlier but rather average in using informal financing.